Question

Which of the following statements about capital structure are correct? Select ALL correct answers. 

• A company needs to consider the current economic climate when making decisions on debt and equity proportions. 

• Having too little debt may increase the risk of default repayment. 

• A company should always finance its business using as much debt as possible in order to optimize the capital structure. 

• Having too much equity may dilute earnings and the value of the original investors.

Answer 1

The correct answers are the 1^st option and the 4^th option.

1^st option – A company needs to consider the current economic climate when making decisions on debt and equity proportions.

4^th option – Having too much equity may dilute earnings and the value of original investors.

Explanation: The cost of debt varies with market conditions and hence a company needs to consider the current economic climate when making decisions on debt and equity proportions as to ensure that its WACC (weighted average cost of capital) is at desired levels.

Too much equity will mean that the same amount of net income is being divided amongst a higher number of shareholders and hence this will lead to reduction in EPS (earnings per share).